Wall Street research change inevitable

But question remains: How can research be funded?

By

NicoleMaestri

NEW YORK (CBS.MW) -- In a stroke of luck or irony, the Securities Industry Association held a conference in Manhattan Tuesday to discuss analyst research and regulation -- just one day after the N.Y. State attorney general got a judge to force Merrill Lynch to change its equity research practices.

In a bold move, New York Attorney General Eliot Spitzer Monday obtained a court order commanding the nation's largest brokerage firm
MER, -2.00%
to disclose in its published research whether a company is an investment banking client or a prospective client. Read more.

A panel of lawyers told the attendees of the SIA conference Tuesday that while Spitzer's move did not have much precedent, it could become a popular tool with politicians during an election year. After all, it will likely garner the support of voters who rode the bull market only to see their swollen portfolios wither with the bear market, they said..

"I guess Eliot Spitzer was really upset we didn't invite him to be keynote speaker," joked SIA President Marc Lackritz.

But the conference attendees, representatives of many of Wall Street's largest firms, were not so amused.

Many seemed perplexed about the emergence of the research analyst as a scapegoat for all that has gone wrong in the markets, and that feeling was underscored by the attorney general's actions.

After all, the media played its role as well, the attendees said, as they used analysts as sources without explaining potential conflicts. Individual investors are to blame also, since they don't take the time to read research reports but make buying and selling decisions on headlines, they said.

But what the conference attendees acknowledged was that whether the blame is fair or not, their industry will be changing as a result of it.

In February, the National Association of Securities Dealers and the New York Stock Exchange submitted proposed rule changes to combat analyst independence issues. The new rules would, among other things, require that analyst pay not be directly tied to specific investment banking transactions, and the investment banking department may not review research reports before they are distributed.

NASD regulation president Mary Schapiro said Tuesday that voluntary standards are not enough.

"Some things clearly need fixing, and it is more than just an image problem," she said. Regulations proposed by the NASD and the NYSE must be implemented, Schapiro said.

Richard Kleinberg, general counsel for National Financial Partners who was attending the conference, supported change, saying conflict of interest is a persistent problem throughout the industry.

"Merrill just happens to be the one in the host seat on this particular matter," Kleinberg said.

The same way the public would be outraged to learn a film critic's salary was tied to the success of a movie, he said, they are outraged to learn analyst compensation is being tied to how well investment-banking business performs.

Charles Hill, director of research at Thomson Financial/First Call, said he was surprised the attorney general acted as he did.

"With the industry so close [to making changes], why not wait and see what happens?" he said.

But it will be a struggle to get the industry to agree on new rules. Stuart Kaswell, general counsel of the SIA, said the NASD and the NYSE rule proposals are "a bit wide of the mark."

Kenneth Josselyn, managing director of Goldman Sachs
GS, -1.86%
and John Faulkner, managing director of Morgan Stanley
MWD, +0.43%
both reviewed the rule proposals and said some would propose tremendous costs for the industry to implement without much progress.

As well, Faulkner said, some proposals put at a disadvantage boutique firms that don't have the same resources to implement the changes.

Schapiro, though, said there is little sympathy in Washington for the burden that new rules will put in the industry.

The lingering question

But Hill and many other participants said one problem has not yet been solved or addressed by the rule changes or the attorney general's actions: How will equity research departments be funded in the future?

"The problem is that the firms can't get paid for research the way they used to be able to," Hill said.

Commission fees no longer generate revenue pools to pay for research departments, and investment-banking fees are seemingly the next to go.

It may be true that as analyst research has been tied to investment banking, it has become less independent, panelists said, but there seems to be no alternatives for funding independent research.

"Do we still have a viable business model within our industry to support research?" asked Frank Fernandez, chief economist of the SIA, when opening a panel discussion.

The overarching answer was that no one knew.

Unless banks find meaningful way to fund research, the NASD and NYSE rule proposals aimed at ensuring analyst independence may ultimately have the effect of changing the entire face of equity research as it becomes a less lucrative business for investment banks.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.